The Story Behind Fed ‘Liquidity’

In a flurry every Thursday evening, much-like catching the coming episode of the ‘must watch’ TV show Dallas, analysts eagerly download the US Federal Reserve’s latest H4.1 Statement. The excitement does not stop there. Calculators at the ready, the numbers are quickly crunched to reveal whether the US Central Bank is adding or subtracting liquidity from American money markets. Below we reproduce the first table from the current H4.1 release:

Why is Fed Liquidity Important?

This balance sheet analysis matters, because as Figure 1 below shows, almost every twist and turn in Fed Liquidity (see below) seems to drive stock prices up and down, evidenced here by the sensitive NASDAQ Index.

Figure 1: Fed Liquidity Injections and NASDAQ Index, 2019-2023

The correlation looks tight, especially for the NASDAQ Index. However, the relationship also holds for the broader S&P500 Index and over longer time spans, as the following scatter chart shows for the period 2010-23. See Figure 2.

Figure 2: Scatterchart of S&P500 and Fed Liquidity, 2010-23 (Weekly)

How Does The US Fed Influence Financial Liquidity?

The mechanics of exactly how Fed Liquidity is derived from its balance sheet is described in the following flow diagram. The method is also provided in more detail in the book Capital Wars (2020, Palgrave Macmillan), but the original idea of ‘Fed watching’ goes back decades and is best credited to the great Henry Kaufman, former research head of US investment banking titan Salomon Brothers, who is the doyen of flow of funds analysis and the originator of “Fed Watching”.

The large orange rectangle depicts the money market, and the arrows show funds entering and leaving this pool. The US Fed is shown on the left and the US Treasury on the right. Money in a modern economy is credit and means of settlement, i.e. legal tender, is ultimately government-backed money. All economies operate in a similar fashion.